We’re emerging from a weird time in the history of mortgages and housing in Canada.
After the financial crisis of 2008-09, mortgage rates plummeted to their lowest point in all of history. And then house prices skyrocketed, especially in Vancouver and Toronto, thanks to a fertilizer made of strong local economies, land use restrictions, foreign investment and dirt-cheap money.
But it seems the ride is coming to an end. The housing market has begun the soft landing that many predicted, as more inventory has come to market and the pace of sales slowed without a massive crash in prices. (That story isn’t all told yet, however.)
Mortgage rates are up, too. After bottoming out in late 2016, rates have begun climbing steadily. The current mortgage rates in Canada are up over a full percentage point from the low-water mark, currently hovering just above the three-per-cent mark.
Following 10 years of unusual activity, this return to normalcy has many people wondering: “How much house can I afford?” And given the uncertainty of what’s coming next, the answer is less simple than it may once have been.
Just do the math for me
The formula for affordability is a combination of the mortgage you can get approved for, plus your down payment.
Mortgage affordability is based on a ratio of your income to expenses. Your gross debt service ratio is the sum of your mortgage payment (principal and interest), property tax, home heating cost, and 50 per cent of condo maintenance fees, divided by your pre-tax income. This number can work out to a maximum of 39 per cent. Your total debt service ratio factors in your other obligations, such as car payments and credit cards, and can add up to no more than 44 per cent of your income.
Simple math shows that someone earning $50,000 per year can afford to spend $1,625 per month on their mortgage, property tax, and heat.
But recently changed mortgage rules require homebuyers to pass a mortgage stress test. To get approved for a mortgage, you now have to show that you can stay within the debt service ratios at a much higher mortgage rate than you actually will have to pay. Even if you can get approved for a mortgage rate of 3.09 per cent, you have to qualify as if you’ll be paying the Bank of Canada’s benchmark qualifying rate, which is currently 5.34 per cent.
That’s a substantial difference, and it erodes a great deal of mortgage affordability. If you could previously afford a $500,000 mortgage amortized over 25 years at 3.09 per cent, the stress test would reduce your affordability to $405,000 – a 19 per cent drop.
Under the stress test, a Canadian earning $50,000 per year buying a home with property taxes of $300 per month and heating costs of $150 per month can only afford a purchase price of $271,000 with a 20 per cent down payment.
Consider your comfort level
This math, however, represents the maximum you’ll be allowed to borrow. And for many of us, spending 39 per cent of our pre-tax income on housing costs isn’t feasible. You’ll want to consider all of the other expenses in your life, like food, transportation and entertainment, and decide how much money is really reasonable to spend on your home.
There’s also the question of maintenance on a home. It’s estimated the average homeowner spends one to four per cent of their home’s value on maintenance each year. Emergencies happen, and there’s no landlord to call on when you’re the homeowner.
That’s why many lenders and financial experts recommend keeping your debt service ratios well below the 39-/44-per-cent maximums. To allow breathing room, it’s suggested to keep your gross debt service ratio (home costs only) under 32 per cent, and your total debt service ratio (including all debt obligations) below 39 per cent.
Will interest rates continue to rise?
That’s why the stress test is there – to help provide a buffer that will keep you from running into trouble when your mortgage comes up for renewal.
But just as you will want to leave a little breathing room when you buy your house, you should consider your ability to swallow a significant rate hike when your mortgage comes up for renewal.
For example, if you take on a mortgage of $500,000 amortized over 25 years with a 5-year fixed rate of 3.09 per cent today, your monthly payment will be $2,389. If your mortgage rate goes up at the end of your term by two percentage points to 5.09 per cent, your new payment would be $2,934. The stress test ensures you will theoretically be able to pay that amount, but a difference in payments of $550 per month could take a significant bite out of your household budget.
A mortgage payment calculator can help you test what your mortgage payment will be under different scenarios to ensure you’ll be able to continue making mortgage payments if and when rates go up.
What if rates go up while I’m house hunting?
Even if you’re not looking to spend at the top of your affordability, any increase in mortgage rates will increase your monthly carrying costs of a new home. Luckily, you can avoid this situation by getting a mortgage pre-approval.
In a nutshell, your mortgage broker can help you lock in a mortgage rate, typically for 90 to 120 days. If rates go up during that time, you’ll still get the initial rate you were offered. If mortgage rates go down, you’ll get the lower of the two.
A mortgage pre-approval can also be helpful because your mortgage broker can tell you with certainty what mortgage amount you’ll be approved for. That, coupled with a rate hold, gives you assurance that you can spend up to your maximum approved purchase price without running into financing problems.
Note that rate holds typically only work with fixed-rate mortgages. Variable mortgages by definition go up and down with the key interest rate set by the Bank of Canada. So even though your mortgage broker can hold a discount to the prime rate (Prime minus 0.25 per cent), your mortgage rate will still be subject to fluctuations in the prime rate.
The bottom line
Different contributors to mortgage affordability are making it harder to afford a home in Canada. Mortgage stress testing and rising mortgage rates have reduced affordability, while home prices have yet to come down in any meaningful way. And because mortgage rates are trending up, long-term affordability should be part of the equation when you’re buying a home.
But that doesn’t necessarily mean you won’t be able to afford a home. With a few tools, like a mortgage pre-approval, you can find out exactly how much house you can afford. And with a little budgeting and forethought, you can determine for yourself how big of a mortgage you’re willing to take on.